Transcript Summary of IS-LM

OPEN ECONOMY MACRO AND THE
EXCHANGE RATE (1)
• Up to now, we have ignored the exchange rate: i.e. the price of foreign
currency in terms of domestic currency.
• Implicitly we have assumed the exchange rate to be fixed (as well as
general price levels, both foreign and domestic).
• We now allow for flexible exchange rates and contrast the workings of
fiscal and monetary policies under different exchange rate regimes
• For any open economy, there will be:
– a demand for foreign currency for imports, investment abroad
– a supply of foreign currency from exports and inward investment
– also international factor income payments, transfers, etc.
• Generally the resulting relative price of foreign and domestic
currencies can display significant volatility.
OPEN ECONOMY MACRO AND THE
EXCHANGE RATE (2)
• The Nominal Exchange rate is usually the number of Foreign
Currency units per unit of Domestic Currency: i.e. number of $ or £
per € (or if you are in the USA, the number of € or £ per $)
• Some countries operate fixed exchange rate regimes, where the
Nominal Exchange rate is fixed: in that case the monetary authorities
mop up and excess supply of foreign exchange by adding to reserves,
and meet any excess demand by running down reserves
• In a fixed exchange rate regime: Ms is endogenous: excess Supply adds
to Foreign exchange reserves and to reserve assets of banks, and thus
to an expansion of Ms. Excess demand similarly leads to a fall in Ms.
• Therefore in a fixed exchange rate regime, an independent domestic
Monetary Policy is impossible (unless there are draconian foreign
exchange controls)
NOMINAL AND REAL EXCHANGE RATES (1)
• The nominal exchange rate is what we observe directly:
• e.g. €1 = $1.50 or $1= €0.67
• However in terms of the effects on Trade (or NX), the real exchange
rate is what matters
• Let e, E, P, Pf = real exch rate, nominal exch rate, Domestic price level
and Foreign price levels respectively.
• Then:
e = E(P/Pf)
• Initially, suppose P = 100 and Pf = 200
• Recall E is no. of $ (foreign currency units) per € (domestic)
• Suppose E = 2.00, then e = 2.00(100/200) = 1
• If P increases to 110, and Pf remains the same, and also E is constant,
then
• e = 2.00(110/200) = 220/200 = 1.1: i.e a real appreciation of the €
NOMINAL AND REAL EXCHANGE RATES (2)
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For levels:
e = E(P/Pf)
For changes:
e/e = E/E + P/P – Pf/Pf
If domestic inflation is 2%, “foreign” inflation is 5% and E/E=0
Then: e/e = 0 + 2% – 5% = – 3%, i.e. a real depreciation of 3%
If domestic and foreign inflation were both 2% and E/E = +20%
Then: e/e = +20% + 2% – 2% = + 20%: a 20% real appreciation
In recent years, many fairly large changes in E have occurred while
inflation rates were roughly equal implying corresponding changes in e
• This bring us to the concept of Purchasing-Power Parity (PPP)
• PPP is a hypothesis about the correspondence between Nominal
Exchange Rates and relative prices, such as to equalise Purchasing
power of a given sum of money in different countries
NOMINAL AND REAL EXCHANGE RATES (3)
• Formally PPP implies: e = 1 = E(P/Pf);  E = (Pf/P)
• and e/e = E/E + P/P – Pf/Pf = 0;  E/E = Pf/Pf – P/P
• Under a fixed Exchange Rate regime as E/E = 0, then PPP implies
that P/P = Pf/Pf , and for a small open economy P/P is clearly the
dependent variable.
• Under a flexible exchange rate regime PPP may imply that E adjusts to
compensate for any difference between P/P and Pf/Pf
• A quick examination of the data reveals that PPP does not apply at
least in the short or medium term: in the very long-term the evidence is
more mixed.
• For the moment, we can assume that e is not constant, and therefore
the relation between NX and e is important.
• Let
NX = NXa + nY – ue
BALANCE OF PAYMENTS EQUILIBRIUM (1)
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A fundamental BOP condition is: NX + NCF = 0
Where NCF = net capital outflow
A higher level of Y reduces NX (via increased import demand)
A higher r also reduces NCF
 increasing Y and r simultaneously will maintain BOP equilibrium. If
capital is perfectly mobile then even very small changes in r will offset
large changes in Y
If E (and e) increases, then a higher r will be needed to maintain BOP
equilibrium (at any given level of Y). B is FRes
Formally: B = f(y, r, e), and dB = f'ydy + f'rdr + f'ede
For any given e, BOP equil implies B = 0 = f'ydy + f'rdr
So dr/dy = - (f'y /f'r)
We can summarise this in a BOP equilibrium locus: BB
BALANCE OF PAYMENTS EQIULIBRIUM (2)
• BB is locus of r, Y giving BOP equilibrium (FRes = 0)
• Above BB, BOP surplus,  + Ms, below BB deficit  – Ms
• Increase in E (or e)  shifts to B1 B1, fall in E  B2B2
r
B1
B1
B
B
B2
B2
0
Y
FISCAL POLICY IN SOE (FIXED-E)
• Fiscal expansion IS2 ; r increases; BOP > 0; + Ms; LM2
• Result: “effective” Fiscal Policy: y y2 (NB caveat re multiplier)
r
LM1
LM2
B
B
IS1
0
Y1
Y2
IS2
Y
MONETARY POLICY IN SOE (FIXED-E)
• Monetary expansion LM2 ; r falls; BOP < 0;  Ms; LM1
• Result: “ineffective” Monetary Policy: y remains at y1
r
LM1
LM2
B
B
IS1
0
Y1
Y
FISCAL POLICY IN SOE (FLEXIBLE-E)
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IS shift leads to E appreciating: this shifts IS again
Result: International “crowding out”
r
LM
B2
B3
B1
B2
B3
B1
IS1
0
y1 y3 y2
IS3 IS2
Y
MONETARY POLICY IN SOE (FLEXIBLE-E)
• LM shift leads to E depreciating
• Shift in BB leads to outward shift in IS
• Result: “effective” monetary policy
r
IS1
IS2
LM1 LM2
B1
B2
B1
B2
0
Y1 Y2
Y
SMALL OPEN ECONOMY MACRO: SOME
PROVISIONAL CONCLUSIONS
• We now see how one cannot have (a) an independent exchange rate
policy; (b) any effective monetary policy and (c) complete capital
mobility
• In the Euro-zone there is practically perfect capital mobility, but for
individual members, no exchange rate policy discretion and no
effective monetary policy
• There is however scope for fiscal policy (but this is blunted by the
openness of individual economies)
• There are also parameters which have been agreed for fiscal policies:
the EU Stability and Growth pact, and there are “Excessive Deficit”
procedures.
• Without going into details: note that the revised pact makes allowances
for the impact of economic cycles, and recent events have necessitated
a general re-think.
Policy In an Open Economy
• Can look at Monetary, Fiscal and Exchange Rate
Policy
• If we think of the purpose of policy is to control Y
then we get
Fixed e
Float e
Fiscal
Effective
Little effect
Monetary Ineffective Effective
• The reason is the automatic effects of BP